How to get real about your emotional risk tolerance

By: | 9:51am EDT February 27, 2014

The current market is making some investors question their allocation strategies amid concerns of volatile equity markets and where bonds might go.

Your portfolio strategy, however, needs to be about how you want to be positioned in the market for the long haul, taking into account your financial risk capacity and emotional risk tolerance, says Sabrina Lowell, CFP®, chief operating officer at Mosaic Financial Partners.

“If you’re investing with a sound, diversified strategy, the conversation shouldn’t be that much different if the market is up, down or flat,” Lowell says. “If you’re not trying to outguess things, you’re just making minor tweaks around the edges. Making big moves, if there’s a lot of upside or downside volatility, can be really expensive in the long run if you make the move at the wrong time.”

Smart Business spoke with Lowell about the current market conditions and setting up a sound investment strategy.

What are the biggest market questions?

When the market is doing really well, some people ask, ‘Should I be moving more into equities? Should I be doubling down?’ That, however, is exactly the wrong strategy.

With standard rebalancing, you typically employ a buy-low, sell-high strategy. So, that could mean taking money out of stocks and deploying it in bonds or other asset classes that aren’t necessarily as correlated with stocks or bonds. Putting more dollars in the stock market could increase your portfolio’s risk profile at just the wrong time.

Another concern is that when interest rates rise, the bond market will go down. Yes, that’s a concern, but it doesn’t mean you should get rid of all bonds. Instead, look at the type of bonds you’re investing in. Diversify with a balance of domestic, international and world strategy bonds for the short and intermediate term with an emphasis on shorter maturity, which is less subject to longer-term volatility.

How should your allocation strategy be set up? How does behavioral finance affect this?

Don’t put as much weight into what the market is currently doing. That doesn’t mean you should have your head in the sand. However, if you’ve employed a sound strategy, and came to a conclusion about how your portfolio should look before the market caught on fire, don’t switch strategies in light of what’s going on now.

Behavioral finance looks at how people react. Take the recency bias, for example. When investors see the market go up for multiple months, they think this pattern, which may not even be a pattern at all, will continue — and statistically that’s not the case. It’s important to set up a strategy you can stick with whether the market is up or down. When you take on too much risk, you set yourself up to take poor actions later, because you will be motivated to sell out when the market is down.

Take a careful look at how your experience, outlook or belief system impacts the investment choices you make. What assumptions are you making? Where are you getting your information? You need to understand your emotional risk tolerance — how much risk you are comfortable taking.

How can you discover your risk tolerance?

There are a number of ways to understand your emotional risk tolerance, including filling out a questionnaire to see where you fall on the risk spectrum.

Then, compare that against your investment strategy and financial risk capacity. Are you taking on more risk than you need to in order to achieve your goals? If you are more risk conservative, what other factors can you control, such as working longer, saving more or modifying expenses.

What happens if a couple’s emotional risk tolerances are different?

More often than not, couples have different emotional risk tolerances. You may already have an inclination of who falls where, but it’s important to get baseline, factual data. Then, you can explore the trade-offs with your financial adviser to find a medium balance. The more conservative person usually carries more weight; if you push him or her to be more aggressive, it can be problematic when things don’t go well.

However, now is a great time to assess risk tolerance because with a strong market you’re not in a high emotional state. In panic mode, it’s difficult to make good decisions. ●